Managerial economics is the application of economic theory and quantitative

methods (mathematics and statistics) to the managerial decision making process. In

general, economic theory is the study of how individuals and societies choose to utilize
scare productive resources (land, labor, capital, and entrepreneurial ability) to satisfy
virtually unlimited wants. Quantitative methods refer to the tools and techniques of
analysis, which include optimization analysis, statistical methods, forecasting, game
theory, linear programming, and capital budgeting.
Economic theory is concerned with how society answers the basic economic
questions of what goods and services should be produced, and in what amounts, how
these goods and services should be produced (i.e., the choice of the appropriate
production technology), and for whom these goods and services should be produced. In
market economies, what goods and services are produced by society is determined not by
the producer, but rather by the consumer. Profit-maximizing firms produce only the
goods and services their customers demand. How goods and services are produced refers
to the technology of production, and this is determined by the firm management. Profit
maximization implies cost minimization. In competitive markets, firms that do not
combine productive inputs in the most efficient (least costly) manner possible will
quickly be driven out of business. The for whom part of the question designates the
individuals who are willing and able to pay for the goods and services produced.
The study of economics is divided into two broad subcategories: macroeconomics
and microeconomics. Macroeconomics is the study of entire economies and economic
systems and specially considers such broad economic aggregates as gross domestic
product, economic growth, national income, employment, unemployment, inflation and
international trade. In general, the topics covered in macroeconomics are concerned with
the economic environment within which firm managers operate. For the most part,
macroeconomics focuses on variables over which the managerial decision maker has
little or no control, although they may be of considerable importance when economic
decisions are made at micro level of the individual, firm, or industry. Macroeconomics
also examines the role of government in influencing these economic aggregates to
achieve socially desirable objectives through the use of monetary and fiscal policies.
 Microeconomics, on the other hand, is the study of the behavior and interaction of
individual economic agents. These economic agents represent individual firms,
consumers, and governments. Microeconomics deals with such topics as profit
maximization, utility maximization, revenue or sales maximization, product pricing,
input utilization, production efficiency, market structure, capital budgeting,
environmental protection, and governmental regulation. Microeconomics is the study of
individual economic agents, such as individual consumers and firms, and the interactions
between them.
Unlike macroeconomics, microeconomics is concerned with factors that are
directly or indirectly under the control of management, such as product quantity, quality,
pricing, input utilization, and advertising expenditures. Managerial economics also
explicitly recognizes that a firm’s organizational objective, usually profit maximization,
is subject to one or more operating constraints (size of firm’s operating budget,
shareholder’s expected rate of return on investment, etc.).
The dominant organizational objective of firms in free-market economies is profit
maximization. Other important organizational objectives, which may be inconsistent with
the goal of profit maximization, include a variety of non-economic objectives, satisfying
behavior and wealth maximization.
The assumption of profit maximization has come under repeated criticisms. Many
economists have argued that this behavioral assertion is too simplistic to describe the
complexity of the modern large corporation and the managerial thought processes
required. Other theories emphasize different aspects of the operations of the modern,
large corporation. Despite these attempts, no other theory of firm behavior has been able
to provide a satisfactory alternative to the broader assumption of profit maximization.
Profit maximization (loss minimization) involves maximizing the positive
difference (minimizing the negative difference) between total revenue and total
economic cost, that is, total economic profit. Total revenue is defined as the price of a
product times the number of units sold. Total economic cost includes all relevant costs
associated with producing a given amount of output. These costs include both explicit,
“out-of-pocket” expenses and implicit costs.
 Economic profit is distinguished from accounting profit, which is the difference
between total revenue and total explicit costs. Total economic profit considers all relevant
economic costs associated with the production of a good or service. Another important
concept is normal profit, which refers to the minimum payment necessary to keep the
firm’s factors of production from being transferred to some other activity. In other words,
normal profit refers to the profit that could be earned by a firm in its next best alternative
activity. Economic profit refers to profit in excess of these normal returns.
Non-economic organizational objectives tend to emphasize such intangibles as
good citizenship, product quality, and employee goodwill. The achievement of other
organizational objectives, such as earning an “adequate” rate of return on investment, or
attaining some minimum acceptable rate of sales, profit, market share, or asset growth, is
the result of satisfying behavior on the part of senior management. Satisfying behavior is
predicated on the belief that it is not possible for senior management to know (some text
missing) associated with running a large corporation. Finally, maximization of share-
holder wealth involves maximizing the value of a company’s stock by maximizing the
present value of the firm’s net cash inflows at the appropriate discount rate.
In summary, managerial economics might best be described as applied
microeconomics. As an applied discipline, managerial economics integrates economic
theory with the techniques of quantitative analysis, including mathematical economics,
optimization analysis, regression analysis, forecasting, linear programming, and risk
analysis. Managerial economics attempts to demonstrate how the optimality conditions
postulated in economic theory can be applied to real-world business situations to
optimize firms’ organizational objectives.

KEY TERMS AND CONCEPTS

Above-normal profit – A positive level of economic profits (i.e., operating profits are
greater than normal profits).
Accounting profit – The difference between total revenue and total explicit costs.
Business cycle – Recurrent expansions and contractions in overall macroeconomic
activity.
Ceteris paribus – The assertion in economic theory that when analyzing the relationship
between two variables, all other variables are assumed to remain unchanged.
Consumption efficiency – The state in which consumers derive the greatest level of
happiness, satisfaction, or utility from the purchase of goods and services subject to
limited income.
Economic efficiency – Also referred to as Pareto efficiency. An economic outcome in
which it is not possible to make one person in society better off without making some
other person in society worse off. Two related concepts are production efficiency and
consumption efficiency.
Economic good – A good or service not available in sufficient quantity to satisfy
everyone’s desire for that good or service at a zero price.
Factors of production – Inputs that are used to produce goods and services. Also called
productive resources, factors of production fall into one of four broad categories: land,
labor, capital, and entrepreneurial ability.
Financial intermediaries – Institutions that act as a link between those who have money
to lend and those who want to borrow money, such as commercial banks, savings banks,
and insurance companies.
Fiscal policy – Government spending and taxing policies.
Incentive contract – A contract between owner and manager in which the manager is
provided with incentives to perform in the best interest of
Macroeconomic Policy: Monetary and fiscal policy, sometimes referred to as the
stabilization policy, macroeconomic policy is designed to moderate the negative effects
of the economic cycle.
Macroeconomics: The study of the entire economies. Macroeconomics deals with the
broad economic aggregates, such as national product, employment, unemployment,
inflation, interest rates and international trade. Macroeconomics also examines the role of
the government in influencing these economic aggregates to achieve some socially
desirable objective through the use of monetary and fiscal policies.
Manager – Worker / Principal: Agent Problem: Arises when workers do not have a
vested interest in a firm’s success. Without a stake in the company’s performance, there
will be an incentive for some workers not to put forth their best efforts.
Managerial Economics: The synthesis of microeconomic theory and quantitative
methods to find optimal solutions to managerial decision making problems.
Market Economy: An economic system characterized by private ownership of factors of
production, private property rights, consumer sovereignty, risk taking, entrepreneurship,
and a system of prices to allocate scarce goods, services and factors of production.
Microeconomic Policy: Government policies designed to promote production and
consumption efficiency.
Microeconomics: The study of the behavior of individual economic agents, such as
individual consumers and firms, and the interactions between them. Microeconomics
theory deals with such topics as product pricing, input utilization, production technology,
production costs, market structure, total revenue maximization, unit sales maximization,
profit maximization, capital budgeting, environmental protection and governmental
regulation.
Monetary Policy: The part of macroeconomic policy that deals with the regulation of the
money supply and credit.
Negative Externalities: Costs of transactions borne by the individuals not the party to
the transaction.
Normal Profit: The level of profits required to keep the firm engaged in a particular
activity. Normal profit represents the rate of return on the next best alternative investment
of equivalent risk.
Ockham’s razor: The principle that, other things’ being equal, the simplest explanation
tends to be the correct explanation.
Opportunity Cost: The highest valued alternative forgone whenever a choice is made.
Owner – Manager / Principal – Agent Problem: Arises when managers do not share
in the success of the day – to – day operations of the firm. When managers do not have a
stake in the company’s performance, some managers will have an incentive to substitute
leisure for diligent work effort.
Positive Externalities: Benefits of a transaction that are borne by an individual not a
party to the transaction.
Post hoc, ergo propter hoc: A common error in economic theorizing which asserts that
because event A preceded event B, that event A caused event B.
Principal – Agent Problem: Arises when there are inadequate incentives for agents
(managers or workers) to put forth their best efforts for principals (owners or managers).
This incentive problem arises because principals, who have a vested interest in the
operations of the firm, benefit from the hard work of their agents, while agents who do
not have a vested interest prefer leisure.
Production Efficiency: The production by a firm of goods and services at the least cost,
or the full and productive employment of the society’s resources.
Pure Capitalism: Describes the economic systems that are characterized by the private
ownership of productive resources, the use of markets and prices to allocate goods and
services, and little or no government intervention in the economy.
Satisfying Behavior: An alternative to the assumption of profit maximization, satisficing
behavior may include maximizing salaries and benefits, maximizing a market share
subject to some minimally acceptable (by share holders) profit level, earning an
“adequate” rate of return on investment, and attaining some minimum rate of return on
sales, profit market share, asset growth, and so on.
Scarcity: Describes the condition in which the availability of resources is insufficient to
satisfy the wants and needs of the individuals and the society.
Total Economic Cost: Includes all relevant costs associated with producing a given
amount of output. Economic costs include both explicit (out of pocket) expenses and
implicit (opportunity) costs.
Total Economic Profit: Economic profit is the difference between the total revenue and
the total economic costs.
Total Operating Cost: Economic cost less normal profit.
Total Operating Profit: Economic profit plus normal profit.

CHAPTER QUESTIONS
1.1 Define the concept of scarcity. Explain the significance of this concept in relation to
the concept of opportunity cost. Are opportunity costs and sacrifice the same thing?
Would you say that a sacrifice represents the cost of a particular decision?

1.2 Explain why the concept of scarcity is central to the study of economics.
1.3 The opportunity cost of any decision includes the value of all

1.4 In economics there is no “free lunch”. What do you believe is the meaning of this
statement?

1.5 Explain how managerial economics is similar to and different from microeconomics.

1.6 What is the difference between a theory and a model?

1.7 Bad theories make bad predictions. Do you agree with this statement? Explain.

1.8 The Law of Demand is not a law. Do you agree with this statement? Explain.

1.9 Evaluate the following statement: Theories are only good as their underlying
assumptions.

1.10 Explain the difference between a theory and a law.

1.11 The Museum of Heroic Arts (MOHA) is a not for profit institution. For nearly a
century, the mission of MOHA has been to “extol and lionize the heroic human
spirit.” MOHA’s most recent exhibitions, which have featured larger than life
renditions of such pulp fiction super heroes as Superman, Wolverine, Batman, Green
Lantern, Flash, Spawn and Brenda Starr, have proven to be quite popular with the
public. Art aficionados who wish to view the exhibit must purchase tickets months in
advance. The contract of MOHA’s managing director, Dr. Xavier, is currently being
considered for renewal by the museum’s board of trustees. Should theories of the firm
based on the assumption of profit maximization play any role in the board’s decision
to renew Dr. Xavier’s contract?

1.12 Many owners of small businesses do not pay themselves a salary. What effect will
this practice have on the calculation of the firm’s accounting profit? Economic profit?
Explain.

1.13 It has been argued that profit maximization is an unrealistic description of the
organizational behavior of large publicly held corporations. The modern corporation,
so the argument goes, is too complex to accommodate such a simple explanation of
 the managerial behavior. One alternative argument depicts the manager as an agent
for the corporation’s shareholders. Managers, so the argument goes, exhibit
“satisfying” behavior; that is, they maximize something other than profit, such as
market share or executive perquisites, subject to some minimally acceptable rate of
return on the shareholder’s investment. Do you believe that this assessment of
managerial behavior is realistic? Do you believe that the description of shareholder
expectations is essentially correct? If not, then why not?

1.14 Suppose you are attending a shareholder meeting of Blue Globe Corporation. A
major shareholder complains that Robert Redtoe, the chief Operating Officer (COO)
of Blue Globe, earned $1,000,000 gross compensation, while Sam Pinkeye, the COO
of Blue Globe’s chief competitor, Green Ball Company, earned only $500,000.
Should you support a motion to cut Redtoe’s compensation? Explain your position.

1.15 One solution to the Principal – Agent Problem in restaurants is the system in
which waiters and waitresses in restaurants work for tips as well as for small boss
salary. Discuss a potential for management with this type of revenue based incentive
scheme.

1.16 Employees of fast food restaurants who work directly with customers do not earn
tips like waiters and waitresses. Discuss possible solutions to the Manager – Worker /
Principal – Agent Problems in fast food restaurants.

1.17 Explain why frequent spot checks by managers to encourage workers to put forth
their best effort may not always be in the best interest of the firm’s owners.

1.18 Under what condition is the assumption of profit maximization equivalent to

shareholder wealth maximization?

1.19 In practice, what is a good approximation of the risk free rate of return on an
investment?

1.20 As a practical matter, how would you estimate the risk premium on an
investment?
1.21 Discuss several reasons why a firm in a competitive industry might earn above –
normal profits in the short run. Will these above – normal profits persist in the long
run? Explain.

1.22 Firm’s that earn zero economic profit should close their doors and seek alternative
investment opportunities. Do you agree? Explain.

1.23 What is likely to happen to the price, quantity and quality of products produced
by firms in competitive industries earning above – normal profits? Cite an example.